Sie sind auf Seite 1von 10

The cost of capital

A reading prepared by Pamela Peterson Drake



O U T L I N E
1. Introduction
2. Determining the proportion of each capital component
3. Determining the cost of each capital component
4. Assembling the pieces: The cost of capital
5. Summary

1. Introduction
The cost of capital is the company's cost of using funds provided by creditors and shareholders. A
company's cost of capital is the cost of its long-term sources of funds: debt, preferred equity, and
common equity. And the cost of each source reflects the risk of the assets the company invests in. A
company that invests in assets having little risk in producing income will be able to bear lower costs
of capital than a company that invests in assets having a higher risk of producing income. For
example, a discount retail store has much less risk than an oil drilling company. Moreover, the cost of
each source of funds reflects the hierarchy of the risk associated with its seniority over the other
sources. For a given company, the cost of funds raised through debt is less than the cost of funds
from preferred stock that, in turn, is less than the cost of funds from common stock. Why? Because
creditors have a senior claim over assets and income relative to preferred shareholders, who have
seniority over common shareholders.
If there are difficulties in meeting obligations, the creditors receive their promised interest and
principal before the preferred
shareholders who, in turn,
receive their promised
dividends before the common
shareholders. If the company is
liquidated, the funds from the
sale of its assets are distributed
first to debt-holders, then to
preferred shareholders, and
then to common shareholders
(if any funds are left). An
example of the possibility of
insufficient funds to pay
claimants is the case of Eastern
airlines, which declared
bankruptcy in 1991, is shown in
Exhibit 1.
Exhibit 1 Case in point: The satisfaction of claims in the
Eastern Airlines bankruptcy and liquidation
I n millions
Claim type
Claim
amount Payout
Secured debt with sufficient collateral $747.1 $747.1
Secured debt with insufficient collateral $453.7 $234.2
Accrued interest on secured debt $308.2 $174.4
Unsecured debt $1,575.0 $175.8
Preferred stock 350.8 $0.0
Common stock $820.0 $0.0
Source: Lawrence A. Weiss and Karen H. Wruck, Information problems, conflicts
of interest, and asset stripping: Chapter 11s failure in the case of Eastern
Airlines, J ournal of Financial Economics, Vol. 48, 1998, p 86.
The Cost of Capital, a reading prepared by Pamela Peterson Drake 1
Eastern Airlines secured creditors had collateral (i.e., security) that was sufficient to pay their claims;
all other claimants did not receive their full claim on the assets of the company because there simply
were insufficient funds available at the time the company liquidated.
For a given company, debt is less risky than preferred stock, which is less risky than common stock.
Therefore, preferred shareholders require a greater return than the creditors and common
shareholders require a greater return than preferred shareholders.
Figuring out the cost of capital requires us to first determine the cost of each source of capital we
expect the company to use, along with the relative amounts of each source of capital we expect the
company to raise. Then we can determine the marginal cost of raising additional capital. We can do
this in three steps:
Step 1: Determine the proportions of each source to be raised as capital.
Step 2: Determine the marginal cost of each source.
Step 3: Calculate the weighted average cost of capital.
We look at each step in this reading. We first discuss how to determine the proportion of each source
of capital to be used in our calculations. Then we calculate the cost of each source. The proportions
of each source must be determined before calculating the cost of each source since the proportions
may affect the costs of the sources of capital. We then put together the cost and proportions of each
source to calculate the company's marginal cost of capital. We also demonstrate the calculations of
the marginal cost of capital for an actual company, showing just how much judgment and how many
assumptions go into calculating the cost of capital. That is, we show that it's an estimate.
The cost of capital for a company is the cost of raising an additional dollar of capital. Suppose that a
company raises capital in the following proportions: debt 40 percent, preferred stock 10 percent, and
common stock 50 percent. This means an additional dollar of capital is comprised of 40 of debt, 10
of preferred stock, and 50 of common stock.
Our goal as financial managers is to estimate the optimum proportions for our company to issue new
capital -- not just in the next period, but well beyond. If we assume that the company maintains the
same capital structure -- the mix of debt, preferred stock, and common stock -- throughout time, our
task is simple. We just figure out the proportions of capital the company has at present. If we look at
the company's balance sheet, we can calculate the book value of its debt, its preferred stock, and its
common stock. With these three book values, we can calculate the proportion of debt, preferred
stock, and common stock that the company has presently. We could even look at these proportions
over time to get a better idea of the typical mix of debt, preferred stock and common stock.
But are book values going to tell us what we want to know? Probably not. What we are trying to
determine is the mix of capital that the company considers appropriate. It is reasonable to assume
that the financial manager recognizes that the book values of capital are historical measures and
looks instead at the market values of capital. Therefore, we must obtain the market value of debt,
preferred stock, and common stock.
If the securities represented in a company's capital are publicly traded -- that is, listed on exchanges
or traded in the over-the-counter market -- we can obtain market values. If some capital is privately
placed, such as an entire debt issue that was bought by an insurance company or not actively traded,
our job is tougher but not impossible. For example, if we know the interest, maturity value, and
maturity of a bond that is not traded and the yield on similar risk bonds, we can get a rough estimate
of the market value of that bond even though it is not traded.
Once we determine the market value of debt, preferred stock, and common stock, we calculate the
sum of the market values of each, and then figure out what proportion of this sum each source of
capital represents. But the mix of debt, preferred stock, and common stock that a company has now
may not be the mix it intends to use in the future. So while we may use the present capital structure
The Cost of Capital, a reading prepared by Pamela Peterson Drake 2
as an approximation of the future, we really are interested in the company's analysis and resulting
decision regarding its capital structure in the future.
2. Determining the cost of each capital component
A. The cost of debt
The cost of debt is the cost associated with raising one more dollar by issuing debt. Suppose you
borrow one dollar and promise to repay it in one year, plus pay $0.10 to compensate the lender for
the use of her money. Since Congress allows you to deduct from you income the interest you paid,
how much does this dollar of debt really cost you? It depends on your marginal tax rate -- the tax
rate on your next dollar of taxable income. Why the marginal tax rate? Because we are interested in
seeing how the interest deduction changes your tax bill. We compare taxes with and without the
interest deduction to demonstrate this.
Suppose that before considering interest expense you have $2 of taxable income subject to a tax rate
of 40 percent. Your taxes are $0.80. Now suppose your interest expense reduces your taxable
income by $0.10, reducing your taxes from $2.00 x 40 percent = $0.80 to $1.90 x 40 percent =
$0.76. By deducting the $0.10 interest expense, you have reduced your tax bill by $0.04. You pay out
the $0.10 and get a benefit of $0.04. In effect, the cost of your debt is not $0.10, but $0.06 -- $0.04
is the government's subsidy of your debt financing. We can generalize this benefit from the tax
deductibility of interest. Let rd represent the cost of debt per year before considering the tax
deductibility of interest, r
*
d
represent the cost of debt after considering tax deductibility of interest,
and t be the marginal tax rate. The effective cost of debt for a year is:
r
d
*
= r
d
(1 - t)
Using our example, r
d
=
$0.10
$1.00
= 10 percent and t = 40 percent and the effective cost of debt is:
r
d
*
= 0.10 (1 - 0.40) = 0.06 or 6 percent per year.
Creditors receive 10 percent, but it only costs the
company 6 percent.
Example 1: The cost of debt
In our example, the required rate of return is easy to
figure out: we borrow $1, repay $1.10, so your
lender's required rate of return of 10 percent per
year. But your cost of debt capital is 6 percent per
year, less than the required rate of return, thanks to
Congress. Most debt financing is not as straight-
forward, requiring us to figure out the yield on the debt -- the lender's required rate of return -- given
information about interest payments and maturity value.
Problem
Suppose the Plum Computer Company can issue
debt with a yield of 6 percent. If Plum's marginal
tax rate is 40 percent, what is its cost of debt?
Solution
r
d
= 0.06 (1 0.40) =0.0360 or 3.6 percent
The Cost of Capital, a reading prepared by Pamela Peterson Drake 3
Example 2: Cost of debt
Problem
Suppose the ABC Company can issue bonds with a face value of $1,000, a coupon rate of 5 percent (paid semi-
annually), and 10 years to maturity at $980 per bond. If the ABC Companys marginal tax rate is 30 percent,
what is its cost of debt?
Solution
Given: FV = $1,000; PV = $980; N = 20; PMT = $25
r
d
= 2.6299% x 2 = 5.2598%
r
d
*
= 5.2598% (1 - 0.30) = 3.6819%
B. The cost of preferred equity
The cost of preferred equity is the cost associated with raising one more dollar of capital by
issuing shares of preferred stock. Preferred stock is a perpetual security -- it never matures. Consider
the typical preferred stock with a fixed dividend rate, where the dividend is expressed as a
percentage of the par value of a share.
The value of preferred equity is the present value of all future dividends to be received by the
investor. If a share of preferred stock has a 5 percent dividend (based on a $100 par value) paid at
the end of each year, the value of the stock today is the present value of the stream of $5's forever:
Value of preferred equity = P = $5 / cost of preferred stock
If the cost of preferred equity is 10 percent, the price a share of stock is worth $5/0.10 = $50.
Therefore,
Cost of preferred equity = r
p
=
Dividend
Price per share

Because dividends paid on preferred stock are not
deductible as an expense for the issuer's tax
purposes, the cost of preferred stock is not adjusted
for taxes -- dividends paid on this stock are paid out
of after-tax dollars.
Example 3: The cost of preferred equity
Problem
Suppose the XYZ Company is advised that if it
issues preferred stock with a fixed dividend of
$4 a share, it will be able to sell these shares
at $50 per share. What is the cost of
preferred stock to XYZ?
C. The cost of common equity
The cost of common equity is the cost of raising
one more dollar of common equity capital, either
internally -- from earnings retained in the company -
- or externally -- by issuing new shares of common
stock. There are costs associated with both
internally and externally generated capital.
Solution
r
p
= $4/$50 = 8%
How does internally generated capital have a cost? As a company generates funds, some portion is
used to pay off creditors and preferred shareholders. The remaining funds are owned by the common
shareholders. The company may either retain these funds (investing in assets) or pay them out to
the shareholders in the form of cash dividends. Shareholders will require their company to use
The Cost of Capital, a reading prepared by Pamela Peterson Drake 4
retained earnings to generate a return that is at least as large as the return they could have
generated for themselves if they had received as dividends the amount of funds represented in the
retained earnings.
Retained funds are not a free source of capital. There is a cost. The cost of internal equity funds (i.e.,
retained earnings) is the opportunity cost of funds of the company's shareholders. This opportunity
cost is what shareholders could earn on these funds for the same level of risk. The only difference
between the costs of internally and externally generated funds is the cost of issuing new common
stock. The cost of internally generated funds is the opportunity cost of those funds -- what
shareholders could have earned on these funds. But the cost of externally generated funds (that is,
funds from selling new shares of stock) includes both the sum of the opportunity cost and cost of
issuing the new stock.
The cost of issuing common stock is difficult to estimate because of the nature of the cash flow
streams to common shareholders. Common shareholders receive their return (on their investment in
the stock) in the form of dividends and the change in the price of the shares they own. The dividend
stream is not fixed, as in the case of preferred stock. How often and how much is paid as dividends is
at the discretion of the board of directors. Therefore, this stream is unknown so it is difficult to
determine its value.
The change in the price of shares is also difficult to estimate; the price of the stock at any future
point in time is influenced by investors' expectations of cash flows farther into the future beyond that
point. Nevertheless, there are two methods commonly used to estimate the cost of common stock:
the dividend valuation model and the capital asset pricing model. Each method relies on
different assumptions regarding the cost of equity; each produces different estimates of the cost of
common equity.
Cost of common equity using the dividend valuation model
The dividend valuation model (DVM) states that the price of a share of stock is the present value
of all its future cash dividends, where the future dividends are discounted at the required rate of
return on equity, r. If these dividends are constant forever (similar to the dividends of preferred
stock, we just covered), the cost of common stock is derived from the value of a perpetuity.
However, common stock dividends do not usually remain constant. It's typical for dividends to grow
at a constant rate. Using the dividend valuation model,
P = D
1
(r
e
- g)
where D
1
is next period's dividends, g is the growth rate of dividends per year, and P is the current
stock price per share. Rearranging this equation to solve instead for r
e
,
r
e
= ( D
1
/ P ) + g
we see that the cost of common equity is the sum of next period's dividend yield, D
1
/P, plus the
growth rate of dividends:
Cost of common equity = Dividend yield + Growth rate of dividends
Consider a company expected to pay a constant dividend of $2 per share per year, forever. If the
company issues stock at $20 a share, the company's cost of common stock is:
r
e
= $2/$20 = 0.10 or 10 percent per year.
The Cost of Capital, a reading prepared by Pamela Peterson Drake 5
But, if dividends are expected to be $2 in the next period and grow at a rate of 3 percent per year,
and the required rate of return is 10 percent per year, the expected price per share (with D
1
= $2
and g = 3 percent) is:
P = $20 / (0.10 - 0.03) = $28.57.
The DVM makes some sense regarding the relation between the cost of equity and the dividend
payments: The greater the current dividend yield, the greater the cost of equity and the greater the
growth in dividends, the greater the cost of equity. However, the DVM has some drawbacks:
How do you deal with dividends that do not grow at a constant rate? This model does not
accommodate non-constant growth easily.
What if the company does not pay dividends now? In that case, D1 would be zero and the
expected price would be zero. But a zero price for stock does not make any sense! And if
dividends are expected in the future, but there are no current dividends, what do you do?
What if the growth rate of dividends is greater than the required rate of return? This implies
a negative stock price, which isn't possible.
What if the stock price is not readily available, say in the case of a privately-held company?
This would require an estimate of the share price.
Therefore, the DVM may be appropriate to use to determine the cost of equity for companies with
stable dividend policies, but it may not applicable for all companies.
Example 4: The cost of equity using the DVM
Cost of common equity using the
capital asset pricing model
The investor's required rate of return is
compensation for both the time value of
money and risk. To figure out how much
compensation there should be for risk,
we first have to understand what risk we
are talking about. The capital asset
pricing model (CAPM) assumes an
investor holds a diversified portfolio -- a
collection of investments whose returns
are not in synch with one another. The
returns on the assets in a diversified
portfolio do not move in the same direction at the same time by the same amount. The result is that
the only risk left in the portfolio is the risk related to movements in the market as a whole (i.e.,
market risk).
If investors hold diversified portfolios, the only risk they have is market risk. Investors are risk
averse, meaning they don't like risk, so if they are going to take on risk they want to be
compensated for it. Investors who only bear market risk need only be compensated for market risk.
If we assume all shareholders' hold diversified portfolios, the risk that is relevant in the valuing a
particular investment is the market risk of that investment. It is this market risk that determines the
investment's price. The greater the market risk, the greater the compensation -- meaning a higher
yield -- for bearing this risk. And the greater the yield, the lower the present value of the asset
because expected future cash flows are discounted at a higher rate that reflects the higher risk.
The cost of common equity, estimated using the CAPM, is the sum of the investor's compensation for
the time value of money and the investor's compensation for the market risk of the stock:
Problem
Consider the Plum Computer Company that currently
pays an annual dividend of $2.00 per share. Plum's
common stock has a current market value of $25 per
share. If Plum's annual dividends are expected to grow
at 5 percent per year, what is its cost of common stock?
Solution

Given: P = $25; D
0
= $2.00; g = 5%
D
1
= D
0
(1 + g) = $2.00 (1 + 0.05) = $2.10
r
e
= ( D
1
/P ) + g = 0.084 + 0.05 = 0.134 or 13.4%
The Cost of Capital, a reading prepared by Pamela Peterson Drake 6
Compensation for the Compensation for
Cost of common equity =
time value of money market risk
+
Let's represent the compensation for the time value of money as the expected risk-free rate of
interest, r
f
. If a particular common stock has market risk that is the same as the risk of the market as
a whole, then the compensation for that stock's market risk is the market risk premium. The market's
risk premium is the difference between the expected return on the market, r
m
, and the expected risk-
free rate, r
f
:
r
e
= r
f
+ (r
m
- r
f
)
where r
f
is the expected risk free rate of interest, is a measure of the company's stock return to
changes in the market's return (beta), and r
m
is the expected return on the market.
The CAPM is based on two ideas that
make sense: investors are risk averse
and they hold diversified portfolios. But
the CAPM is not without its drawbacks.
First, the estimates rely heavily on
historical values -- returns on the stock
and returns on the market. These
historical values may not be
representative of the future, which is
what we are trying to gauge. Also, the
sensitivity of a company's stock returns
may change over time; for example,
when the company changes its capital
structure. Second, if the company's stock
is not publicly-traded, there is no source for even historical values.
Example 5: The cost of equity using the CAPM
Problem
The Plum Computer Company's common stock has an
estimated beta of 1.5. If the expected riskfree rate of
interest is 3 percent and the expected return on the
market is 9 percent, what is the cost of common stock
for Plum Computer Company?
Solution
Given: r
f
= 3%; r
m
= 9%; = 1.5
r
e
= r
f
+ (r
m
r
f
)
r
e
= 3% + 1.5 (9% 3%) = 12%
3. Assembling the pieces: The cost of capital
The cost of capital is the average of the cost of each source, weighted by its proportion of the total
capital it represents. Hence, it is also referred to as the weighted average cost of capital
(WACC) or the weighted cost of capital (WCC). The weighted average cost of capital is:
WACC = w
d
r
d
*
+ w
p
r
p
+ w
e
r
e

where
w
d
is the proportion of debt in the capital structure;
w
p
is the proportion of preferred stock in the capital structure; and
w
e
is the proportion of common stock in the capital structure.
As you raise more and more money, the cost of each additional dollar of new capital may increase.
This may be due to a couple of factors: the flotation costs and the demand for the security
representing the capital to be raised.
The Cost of Capital, a reading prepared by Pamela Peterson Drake 7
As you raise more and more money, the cost
of each additional dollar of new capital may
increase. This may be due to a couple of
factors: the flotation costs and the demand
for the security representing the capital to be
raised. For example, the cost of internal funds
from retained earnings will differ from the
cost of funds from issuing common stock due
to flotation costs. If a company expects to
generate $1,000,000 entirely from what's
available in internal funds -- retained earnings
-- there are no flotation costs. But if the
company needs $1,000,001, that $1 above
$1,000,000 will have to be raised externally,
requiring flotation costs.
Example 6: Calculating the WACC
Problem
Consider the Plum Computer Company once again.
Suppose Plum will raise capital in the following
proportions: Debt: 40 percent; Preferred stock: 10
percent; Common stock: 50 percent. What is Plum's
weighted average cost of capital if its cost of debt is 3.6
percent, its cost of preferred stock is 8 percent, and its
cost of common stock is 12 percent?
Solution
WACC = 0.40 (0.036) + 0.10 (0.08) + 0.50 (0.12)
WACC = 0.0144 + 0.008 + 0.06
WACC = 0.0824 or 8.24%
Additional capital may be more costly since
the company must offer higher yields to entice investors to purchase ever larger issues of securities.
Considering the effects of flotation costs and the additional yield necessary to entice investors, we
most likely face a schedule of marginal costs of debt capital and a schedule of marginal costs of
equity capital. Hence, we need to determine at what level of raising funds the marginal cost of capital
for the company changes.
Exhibit 2 Return on capital v. cost of capital
Let's see what maximizing shareholder
wealth means in terms of making
investment and financing decisions.
To maximize owners wealth we must
invest in a project until the marginal
cost of capital is equal to its marginal
benefit. What is the benefit from an
investment? It is the internal rate of
return -- also known as the marginal
efficiency of capital. If we begin by
investing in the best projects (those
with highest returns), and then
proceed by investing in the next best
projects, and so on, the marginal
benefit from investing in more and
more projects declines.
Also, as we keep on raising funds and
investing them, the marginal cost of funds increases. To maximize shareholders' wealth, we should
invest in projects to the point where the increasing marginal cost of funds is equal to the marginal
benefit from our investment. Relation between the marginal cost of capital (MCC) and the marginal
return on investment (IRR) is shown in Exhibit 2. The point at which the marginal cost and marginal
benefit intersect is the optimal capital budget. This is the point at which the value of the company is
maximized.
0%
5%
10%
15%
20%
25%
$10 $20 $30 $40 $50 $60
Additional capital
Return or
cost of
capital
IRR MCC

4. Getting real with the marginal cost of capital
Determining the cost of capital appears straight-forward: find the cost of each source of capital and
weight it by the proportion it will represent in the company's new capital. But it is not so simple.
There are many problems in determining the cost of capital for an individual company.
The Cost of Capital, a reading prepared by Pamela Peterson Drake 8
Consider, for example,
How do you know what it will cost to raise an additional dollar of new debt? You may seek
the advice of an investment banker. You may look at recent offerings of debt with similar risk
as yours. But until you issue your debt, you will not know for sure.
The cost of preferred equity looks easy. But how do you know, for a given dividend rate,
what the price of the preferred stock will be? Again, you can seek advice or look at similar
risk issues. But until you issue your preferred stock, you will not know for sure.
The cost of common equity is more perplexing. There are problems associated with both the
DVM and the CAPM.
In the case of the DVM: what if dividends are not constant? What if there are no current
dividends? And the expected growth rate of dividends is merely an estimate of the future.
In the case of the CAPM, what is the expected risk-free rate of interest into the future? What
is the expected return on the market into the future? What is the expected sensitivity of a
particular's asset's returns to that of the market's return? To answer many of these
questions, we may derive estimates from looking at historical data. But this can be
hazardous.
Estimating the cost of capital requires a good deal of judgment. It requires an understanding of the
current risk and return associated with the company and its securities, as well as of the company's
and securities' risk and return in the future.
If you are able to derive estimates of the costs of each of the sources of capital, you then need to
determine the proportions in which the company will raise capital. If your company is content with its
current capital structure and you expect to raise capital according to the proportions already in place,
your job is simpler. In this case, the proportions can be determined by estimating the market value of
existing capital and calculating the weights.
On the other hand, if your company raises capital in proportions other than its current capital
structure, there is a problem of estimating how this change in capital structure affects the costs of
the components. Consider a company that has a current
capital structure, in market value terms, of 50 percent
debt and 50 percent common stock. What happens to
the market value of each component if the company
undergoes a large expansion and raises new funds solely
from debt? This increase in debt may increase the cost
of debt and the cost of common stock. This will occur if
this additional debt is viewed as significantly increasing
the financial risk of the company -- the chance that the
company may encounter financial problems -- thereby
increasing the cost of capital. But this increase in the
use of debt may also decrease the cost of capital. This
could result because the company will be using more of
the lower cost capital -- debt.
Exhibit 3: Costs of capital for different
industries, 2005
Industry Cost of
capital
Advertising 9.03%
Air Transport 8.40%
Beverage 5.83%
Biotechnology 10.28%
E-commerce 18.14%
Internet 16.65%
Petroleum 6.64%
Retail store 8.16%
Trucking 6.84%
Wireless networking 13.58%
Source: Aswath Damadoran,
Whether the cost of financial risk outweighs the benefit
from the tax deductibility of interest is not clear -- and
cannot be reasonably forecasted.
http://pages.stern.nyu.edu/~adamodar/
Estimates of the cost of capital require a great deal of information on individual companies, as well as
forecasts of the return on a risk-free asset and on the market. Estimates of costs of capital for
several different industries for 2005 are shown in Exhibit 2. As you can see, these costs of capital
reflect the business and financial risk of companies; for example, the wireless networking industry
has a great deal of business risk and companies in this industry experience higher costs of capital.
The Cost of Capital, a reading prepared by Pamela Peterson Drake 9
5. Summary
The cost of capital is the marginal cost of raising additional funds. This cost is important in our
investment decision making because we ultimately want to compare the cost of funds with the
benefits from investing these funds. The cost of capital is determined in three steps: (1) determine
what proportions of each source of capital we intend to use; (2) calculate the cost of each source of
capital, and (3) put the cost and the proportions together to determine the weighted average cost of
capital.
The required rate of return on debt is the yield demanded by investors to compensate them for the
time value of money and the risk they bear in lending their money. The cost of debt to the company
differs from this required rate of return due to flotation costs and the tax benefit from the
deductibility of interest expense. The required rate of return on preferred stock is the yield
demanded by investors and differs from the company's cost of preferred equity because of the costs
of issuing additional shares (the flotation costs).
The cost pf common equity is more difficult to estimate than the cost of debt or preferred stock
because of the nature of the return on stock: Dividends are not guaranteed nor fixed in amount, and
part of the return is from the change in the value of the stock. The dividend valuation model and the
capital asset pricing model are two methods commonly used to estimate the required rate of return
on common equity. The DVM deals with the expected dividend yield and is based on an assumption
that dividends grow at some constant rate into the future. The CAPM assumes that investors hold
diversified portfolios, so they require compensation for the time value of money and the market risk
they bear by owning the stock.
The proportion of each source of capital that we use in calculating the cost of capital is based on
what proportions we expect the company to raise new capital. If the company already has a capital
structure -- a mix of debt and equity it feels appropriate -- then that same proportion of each source
of capital, in market value terms, is a good estimate of the proportions of new capital.
The cost of capital is the cost of raising new capital. The weighted average cost of capital is the cost
of all new capital for a given level of financing. The cost of capital is a marginal cost -- the cost of an
additional dollar of new capital at a given level of financing.
In determining the optimal amount to spend on investments, the relevant cost is the marginal cost,
since we are interested in investing until the marginal cost of the funds is equal to the marginal
benefit from our investment. The point where marginal cost = marginal benefit results in the optimal
capital budget.
The actual estimation of the cost of capital for a company requires a bit of educated guesswork, and
lots of reasonable assumptions. Using readily available financial data, we can, at least, arrive at a
good enough estimate of the cost of capital.

The Cost of Capital, a reading prepared by Pamela Peterson Drake 10